They’re Running Toward the Fire

"While investors appear exuberant about the prospect for Fed easing, they seem largely unaware that initial Fed easings have almost invariably been associated with U.S. recessions. They’re running toward the fire."

One of the most important warnings offered by firefighters is simple: get out early. In the face of wildfires, some homeowners get the idea of staying in their homes and riding it out. As one firefighter warned “The point is to go.” But if you don’t, it’s better to stay than to panic and run in the midst of a firestorm of smoke and embers. It’s not the fire that gets you. It’s the heat. Even before the flames reach the house, it can be fatal to stand outside trying to protect what you have (h/t John Galvin).

Similarly, our “Exit Rule for Bubbles” is straightforward: You only get out if you panic before everyone else does. You have to decide whether to look like an idiot before the crash, or look like an idiot after it.

Worse, investors often capitulate into panic selling only after their losses have become extreme. By then, it’s too late. It’s not the fire that gets them. It’s the heat. Once the warning signs are flashing, get out early. Attempting to squeeze the last bit out of a vulnerable, hypervalued market is what value investor Howard Marks describes as “getting cute.”

The key is that overvaluation is not enough. Extreme overvaluation can persist for long periods of time if investors have a speculative bit in their teeth. In prior market cycles across history, an effective approach would have been to tolerate overvaluation until either a) uniformly favorable market internals gave way to dispersion and divergence, indicating that investors had shifted from a speculative mindset to a risk-averse one, or b) extreme “overvalued, overbought, overbullish” features indicated that speculation had reached a precarious limit. Once divergent internals or overextended syndromes emerged, overvaluation typically permitted steep and often immediate market losses.

Indeed, those considerations were exactly the ones that allowed us to anticipate the 2000-2002 and 2007-2009 collapses, and to shift to a constructive outlook in-between. Our value-conscious discipline was enormously effective in multiple complete market cycles into 2009.

The advancing half-cycle since 2009 has been legitimately “different” from history in one specific way. While market internals have continued to be an effective gauge of speculation even amid the Federal Reserve’s policies of quantitative easing and zero interest rates, it was detrimental, in this cycle, to act on the idea that speculation had any reliable “limit” at all. To be clear, I was wrong. As long as investors had a speculative bit in their teeth, as evidenced by uniform market internals, even the most extreme “overvalued, overbought, overbullish” syndromes had no consequence.